We like Japan. And we’ve liked it for a long time. But it hasn’t been our most rewarding investment so far.
A horrendous bear market began in 1990. The Nikkei 225 then hit rock bottom at below 8,000 in March 2003 (along with most other global markets). By 2007, it was back over 18,000 and things seemed to be going well. Then along came the global financial crisis.
Now the Nikkei isn’t really far off where it was back in 2003. And the outlook really isn’t pretty, frankly.
There are plenty of reasons to fret about Japan. The spat with China over a group of islands in the East China Sea has dented demand for Japanese goods in China. It doesn’t help that China’s economy was already slowing down anyway.
But the key issue for Japan is its ludicrously strong currency. This has been a mixed blessing for overseas investors. On the one hand, it has protected them from the worst of the Japanese bear market.
James Hunt of US asset manager Tocqueville, a Japan bull, notes that while we think of the Japanese market as being a terrible laggard, that’s mainly down to the strength of the yen. If you price the market in dollars, then the Nikkei and the S&P 500 in the US traded very closely in the decade from 2000.
However,the yen is now becoming a serious problem. Over the last two years, even in dollar terms, Japan has fallen behind. Japanese stocks ‘broke ranks in 2011 and have lagged the S&P 500 by some 25% over the last two years.’
It’s quite simple. Japan exports a lot of stuff. A strong currency makes exports expensive. There’s only so much that people will pay, even for good quality exports.
Japan’s Market
Has Been Getting Steadily Cheaper
Has Been Getting Steadily Cheaper
Yet, as Hunt also notes, over the past 12 years, Japanese companies have improved on several key measures. As a whole, Japanese companies are more profitable – their margins are bigger – than they were in 2000. On an absolute basis, they are also making more money. And ‘the return on equity has increased from around 6% to around 10%.’
Yet because investors haven’t been keen to buy in to Japan, its companies have also become steadily cheaper. The average dividend yield has grown from 0.8% to 2.3%. The price/earnings ratio has slid, as has the price to book value.
And investors still aren’t willing to pay up for Japanese stocks. Indeed, global fund managers now have their lowest net exposure to Japan in ten years, according to the Merrill Lynch Global Fund Manager survey.
But this is a good sign. It’s not that fund managers are stupid. But they have a tendency to herd. If everybody is investing in one area, then that means there’s no one left to join the party. The result is that the party usually ends soon after, in a horrible panic.
On the other hand, if almost no one is investing in a specific area, then the only way is up. If there’s hardly any money being allocated to Japan, then even if there’s more bad news up ahead, it can’t have much impact. And if things start to improve just a little bit, then even a relatively small amount of added investment could have a big impact on stock prices.
Japan is Reaching a Tipping Point
The big question with all of these tremendous value opportunities of course, is ‘what’s the catalyst’? What’s going to happen to make the market recognise the great value that’s here?
This question doesn’t worry me quite as much as it does your average fund manager. Fund managers always look for catalysts and trigger-points. That’s because they aren’t worried about what happens to their fund in ten years’ time.
They’re worried about what their quarterly performance figure is going to look like. So they’re not inclined to be patient. They want performance right now, not five years from now.
I, on the other hand, have at least 30 years to go before I retire (and that’s probably being optimistic these days). So I’m happy to buy assets that I believe are cheap and give them some time to come good.
That said, there are a couple of very clear catalysts that could make things move quite quickly. That’s the forthcoming election (on 16 December), and the increasing pressure on the Bank of Japan to do something about the strong yen.
Japan has been printing money. But it’s not been printing enough – certainly not to compete with the likes of the Federal Reserve and the Bank of England. In effect, Japan has been a massive loser in the global race between countries to devalue their currencies and export their way out of trouble.
Anyone operating under the illusion that we live in a world of free-floating currencies where the market sets the value of each nation’s money needs to wake up.
Beyond the yen, most Asian currencies are pegged to the dollar in one way or another. The US hasn’t explicitly said that it wants a weaker dollar, but that’s clearly at least one reason for Ben Bernanke’s constant attacks on the currency. In the UK, Mervyn King has gently nodded to the benefits of a weaker pound on several occasions in the past.
The Swiss have pegged their own currency to the euro to protect their economy from the flood of ‘safe haven’ money seeking refuge over its border. Indeed, one of the ways you’ll know that the eurozone crisis is ending, is that this peg is lifted.
So you can see why the Japanese might be getting annoyed. They are being penalised by the willingness of other countries to hammer their own currencies.
As a result, this year the Bank of Japan come under steadily more pressure to weaken the yen. Japan’s short bull run at the start of this year came as a result of the Bank setting a 1% inflation target, which helped the yen weaken sharply.
The yen strengthened again later in the year as the usual panic over the eurozone hit markets. But now it is off on another fit of weakness as investors hope for more aggressive money-printing from the Bank of Japan after the election.
Will this continue? The truth is I don’t know. I hate to second-guess politicians or the results of elections. The good news is that in this case I don’t have to. Japan is cheap. Whether the catalyst that persuades markets to recognise this comes tomorrow or in a year’s time is by-the-by.
John Stepek
Contributing Editor, Money Morning
Publisher’s Note: This article originally appeared in MoneyWeek
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